The SEC’s sweeping new private fund rules are “flawed from root to branch” and should be scrapped, lawyers for a handful of trade groups have told federal judges.
“The commission conceded that this rule will cost billions and commandeer millions of hours of employee time, but is unable to cite a shred of evidence that the rule – aimed at ‘protecting’ the largest, most savvy investors on the planet – is warranted,” Gibson, Dunn & Crutcher partner Eugene Scalia and his colleagues say in an opening brief which was filed on behalf of six trade associations in the Fifth Circuit Court of Appeals in Dallas on Thursday. “Each part of the rule is unnecessary, unworkable, and unduly burdensome – and the commission failed to establish otherwise.”
“The gaping holes in the commission’s action,” Scalia and his colleagues add, “include a failure to put key last-minute additions to the rule out for public comment, and a failure to offer any serious projection of the rule’s likely economic effects. The rule is flawed from root to branch, and this court should set it aside.”
A divided commission adopted the new private funds rules in August. Among other things, the new rules require registered private fund managers to obtain fairness opinions on secondaries deals they lead, to distribute quarterly expense reports to investors and to conduct yearly compliance reviews. The rules also require all private funds – registered or not – to disclose side letter terms to their investors and to obtain investors’ informed consent before charging exams and investigatory expenses to a fund, charging non-pro-rata fees, opening credit lines or borrowing from a fund’s clients or reducing claw backs to offset taxes.
Combined, they represent the most seismic changes to private fund regulation in the US since Dodd-Frank.
Ire focuses on one rule
Within days of the SEC’s vote, the National Association of Private Fund Managers, the Alternative Investment Management Association, the American Investment Council, the Loan Syndications and Trading Association, the Managed Funds Association and the National Venture Capital Association filed suit in Texas to vacate the new rules. Thursday’s brief is the association’s first and most comprehensive argument against the rules.
The Fifth Circuit covers Texas, Louisiana and Mississippi. Private fund advocates planned to bring their suit there because the Fifth Circuit judges are thought to be more hostile to federal regulation than other circuits.
Industry advocates don’t like the new rules broadly, but two elements are especially irksome. The first is the “guidance” language where regulators claim that accelerated monitoring fees and indemnification clauses may well be per se breaches of managers’ fiduciary duties. The second –and most important, from the trade groups’ point of view – element is the SEC’s reliance on rule Sec 211 (h) of the Investment Advisers Act, amended under Dodd-Frank.
That section directs the SEC, “where appropriate,” to “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the commission deems contrary to the public interest and the protection of investors.”
The rule, critics say, gives the SEC unprecedented license to regulate private funds in the future.
‘This massive reformation’
The trade associations have made clear they’re worried that, if courts allow the new rules to stand, the SEC will use Sec 211 for even more onerous and expensive rules.
“As for statutory authority for this massive reformation, the commission has none,” Scalia writes in Thursday’s 89-page brief. “The agency’s ‘best’ authority is a random, ancillary provision, titled ‘Other Matters,’ from a section of the Dodd-Frank Act that has never been applied to private-fund advisers. Instead, that provision, by its plain terms, applies to ‘retail customers,’ ie Main Street investors who are generally not eligible to invest in private funds.”
Dodd-Frank imposed “limited” regulations on private funds, Scalia and his colleagues claim in the brief. But “Congress never authorized the Commission to redesign ‘the governance structure’ of private funds,” the brief states. “Rather, Congress set that governance structure; the commission’s job is to give it effect, not undermine it.”
SEC officials declined to comment for this story. The commission has until December 15 to file its own brief in the case. Amicus briefs on behalf of the trade groups are due November 8, amicus briefs on behalf of the SEC are due December 22. The trade groups’ reply brief is due January 22. Oral arguments have not been scheduled.